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Fool Portfolio Report - Tuesday, July 23, 1996

NORTHERN VERMONT, July 23, 1996 -- An otherwise blissful, pristine day
up here in Vermont was clouded in on all sides by the market storming our
Foolish stocks, touching us up to the tune of 8.75% in losses while the S&P
500 fell 1.09% and Nasdaq was off 2.98%.

After market-close yesterday, Microsoft posted strong 4th quarter numbers
of $2.26 billion in sales, $559 million in net income, and 87 cents per share.
The EPS figure came in two pennies above Street projections and these springtime
profit margins of 24.7% exceeded all expectations. For the umpteenth quarter
in a row, Microsoft steered down expectations at the end of the marking period
and the market obliged, promptly dunking MSFT shares $7 3/4 to $112.

The Microsoft guidance again shook the land. The Nasdaq's sell-off today
makes for an 11.5% drop in the month of July, and puts that index in the
red for 1996. In mid-May, the NAZ was up nearly 20% for the year. Those gains
are all gone now. During that erasure, The Fool Portfolio has seen its returns
dissipate from a shocking 120% gain for the year amidst April and May flowers
and showers down to its perch now, up 16.46% for 1996.

Before jumping into a review of Sears' 2nd quarter report, announced last
Thursday, I'd like to consider this portfolio in its proper context, think
for a few seconds about the performance of our stocks, and mumble on incoherently
for a few minutes about what it all means to the financial world.

This morning I received notice that much of the financial world was focusing
its eyes on our portfolio, its decline, and that there was great fanfare
and merrymaking up and down the street of Wall in New York City. No Fool
need wonder why that is so. We live in a relatively open and heatedly competitive
marketplace. Mutual fund managers battle with one another, newsletter publishers
grit their teeth over fax machines, full-service brokers needle discount
brokers, and the financial media does its level best to make sense of the
whole strudel.

Sadly, there is one creature that all but one of the aforementioned
competitors despises: The autonomous individual investor. The bloke who believes
he can make his own mind up. The housewife that statistics tell us is far
more likely to use the stock market as a savings vehicle, as a haven for
long-term capital growth, than as a money pit. The thirteen-year-old Phoenix
Suns fan who has purchased $247-worth, or four shares, of Nike stock over
the last twelve months. Your great uncle who, fed up with market
underperformance, has transferred 90% of his savings into the Vanguard Index
Fund and 10% into Intel, Microsoft, General Electric and General Motors over
the past eight months.

What value is there in this for your average financial institution? Very
little. Under the existing business models on Wall Street, patience and
accountability and bottom-line performance records are tertiary at best.
The patient investor does not generate commissions. The investor that holds
management numerically accountable does not dive into the world of well-marketed
mutual funds. And bottom-line performance records are currently unheard of
in the land of financial newsletters, which are not presently required by
law or conscience to report transaction costs, spreads, nor to compare their
performance to the S&P 500.

If today Wall Street is looking in on us, the individual investor, hoping
to expose fatal flaws, emotionalism and rampant underperformance, I would
suggest they would do better to look out at the entire financial industry
today. It's an industry that is badly in need of a restructuring heavily
in favor of client service, of long-term bottom-line growth, education, and
of rigorous accounting.

Today, brokers are still compensated based on the number of trades they
make. Between 1986 when it went public and today, Microsoft has compounded
57% annual growth. An investment in the Redmond giant then would have turned
$10,000 into over $900,000 today. Taxes would take it down just below $600,000.
Now, had you been with a full-service brokerage firm, well, what in their
business structuring would have motivated them to advise your holding on
tight to this issue every step of the way? Very little. Compensated off the
number of trades, they much prefer your activity. If the fee is $150 per
trade, it hurts them to see your account rise $575,000 over ten years whilst
earning them only $150 on the way in and $150 on the way out. Much more
attractive is movement in and out of Microsoft two times each year, $600
in annual commissions, ten-year transaction fees of $6,000, and certainly
considerably less than $575,000 in after-tax value in your account today.

This is bad business. It rewards activity for the sake of activity. It
compromises long-term growth for the client, replacing it with short-term
corporate profitability. It isn't fundamentally a service. And this isn't
to say for a second that there aren't numerous individual brokers who have
found ways to serve and reward their clients. I'm speaking of the system
here. It's a system that puts those trying to do what is right, what is mutually
profitable in excess of market-average growth, and what is beneficial at
a disadvantage. Taking advantage of the system for the client's benefit is
considerably more difficult than taking advantage of the system for the
professional.

This is a point which I'm willing to debate publicly with anyone.

Another which follows neatly in tow is the present structuring of compensation
in the mutual fund industry. Management is paid a percentage of total assets
under management. For illustration's sake, let's settle on a 2% fee. The
mutual fund with $100 million under its belt is then paid $2 million annually.
The $500 million fund takes in $10 million annually. And the $5 billion fund
earns its managers $100 million each year.

There are some interesting thresholds here. Which would be better for
the $100 million fund to beat the market by 10% and end up with $125 million
under management in year two or to flood the market with advertising and
willingly underperform market average? You play the game for a second, Fool.
Do you think that Joe and Joanne Average in America have any understanding
of what market average growth means?

I can tell you that the mutual fund industry has an answer to that, and
the answer is no. No clue. Now, sure, beating the market is advantageous,
but market underperformance coupled with spectacular marketing. . . that's
a nice business to be in right now. Heck, open up any investment magazine
and you'll find handfuls of mutual funds gloating over 1-, 3- and 5-year
records of underperformance. They flaunt it. That's their prerogative.

But what happens now in an open environment where education and customer
service are the priority? I suggest that The Motley Fool has orchestrated
the first step in what will at least be a ten-step, five-year remodeling
of the financial towers that have looked out and down on America from Manhattan.
It isn't a revolution, in my mind. This is work that will strengthen our
nation, tug us out of consumer, budget and trade deficits and that will result
in greater fiscal conservatism, self-responsibility, prudence and literacy.

And this isn't a one-company project. It's an undertaking that will take
many hands. We have welcomed and will continue to welcome a number of corporate
partners into this mission. And I would suggest that those on the institutional
side regard this forum and ongoing developments as an opportunity, not a
threat. Because out of necessity, the business models are being transformed
rapidly. The lid is off the box, the ideas are being spread, and people with
more than three years to invest are only going to pay up for market
outperformance---since they can meet market average with the Vanguard Index
Fund. Vanguard kicked off this radical shift. Don't expect that we're heading
back from whence we came, with fewer total investors, absent any elementary
financial education, and with amateur-style accounting from one firm to the
next. The future holds higher education, more information, strict accountability,
and an ongoing open and national conversation.

I say this because The Motley Fool is far more about this industry-level
restructuring than it is about this portfolio. We have said this every step
of the way, and I say it again now with our portfolio up 117% versus S&P
gains of 37%. The rise and fall of America Online and Iomega over that time
is of interest, but peripheral. And I would suggest that investors look at
a few other outstanding and comparably popular managed and unmanaged portfolios
here, from The Dow Dividend to Uptrend's Health Portfolio to The Edible Eight
each of which is soundly outperforming the market, their comparable mutual
funds, and yet each of which is primarily focused on the education of the
client.

This is the future. We're not trying to take it all ourselves. But it
is the future. Rather than denying that, we hope that the industry broadly
will mobilize to participate in it. Many are in the process of it.

As I noted in last week's report, I wanted to give today over to coverage
of Sears (NYSE:S), which announced earnings of $0.67 on Thursday, beating
Street consensus figures of $0.63. Sears, one of the three Dow stocks that
we purchased in August, 1994 and then added to---according to the model---again
in August, 1995, has been an outstanding investment. The stock is up 41%
since last August, and was up more than 25% for us in the previous year.

During that time, we've seen continuing and aggressive moves by Sears
to pare back their exposure to non-retailing businesses. Gone are the days
of insurance and investment banking. Sears is primarily a provider of home
furnishing, apparel and automobile products and services. The focus has led
to tighter quality controls, sharpened business models, greater efficiency,
debt removal, and a rapid climb in shareholder value. This'll make for a
great case study someday, titled "Doing What You Do Better" or "Don't Try
to Be The Everything."

On Thursday, when Sears posted Street beating numbers, the stock was trading
at $46 1/4. A few short weeks back, the stock was bouncing around above $50.
With stronger numbers on the table, our retailing behemoth is a good deal
squatter, a bit shrunken. The stock closed today at $40 3/4.

Why?

Some of it is certainly happening up at the macro level, where inflation
meets the interest rate. Tough to quantify that but certainly the now 20%
decline off recent highs isn't all the work of Mr. Market.

Sears announced $9.1 billion in quarterly sales, $274 million in earnings,
and 67 cents in earnings. The company is sporting 3% profit margins, which
should improve over the second half of 1996 with growth moving from their
hard goods (tires, et cetera) to soft goods (school clothing, et cetera).

Disappointing for the quarter was certainly their international effort.
Off $700 million in revenues, Sears lost $14 million abroad. Canadian and
Mexican economies continue to struggle. And Sears offered that they would
be scaling back inventory committments and cutting costs on foreign soil.
Sears might do well to tug pages out of the GE handbook on this score,
eliminating the worst-performing stores rather than waiting for stronger
international markets to float all boats higher.

Good news on the credit side for the Company, though, with total number
of active credit accounts ranging up to 25 million. Over the past decade,
Sears has watched as use of its credit-card has deteriorated. Thus far in
1996, that trend has reversed. On the downside, personal bankruptcies were
up significantly over the same period last year, and this has investors wondering
about the health of recent sales and the limitations on future growth. Some
propose that consumers don't quit, others propose that consumer debt is ranging
high enough that they won't have much choice. One thing is for certain. .
. there's plenty of growth for the national creditor willing to act contrarily
and actually instruct customers to manage their exposure, to be more prudent.

So where to now for Sears? Analyst Alan Rifkin at Dain Bosworth upgraded
estimates to $3.05 for 1996 and $3.45 for 1997. With greater controls in
place internationally, aggressive management of its debt, and a move toward
higher margins into the end of the year, I'd price Sears at 14x-15x year-forward
earnings, $50-$52 a share into the New Year, or a potential for 20-30% growth
from here.

As for the rest of the Fool Portfolio today, well, Dave and I lost some
more money. Iomega and America Online continued their precipitous fall. The
questions remain: Are these bottom-line growth companies? How well will they
stave off competition? How identifiable and well-regarded are their brands?
Are these merely 5% profit-margin businesses, or will the two eventually
push profits up past ten cents off every dollar in sales?

Answers to these questions and more in the months ahead. In the meantime,
if you're uneasy, click your shoes three times fast and repeat after me:
Beating the Dow, Beating the Dow, Beating the Dow. The Motley Fool Portfolio
may be 14% ahead of the market this year, but the Dow portfolio is 7% up
with less volatility and less angst. Just read through the Chevron, Sears
and General Electric folders as I do, and you'll see.

Both are presently ahead of more than 95% of mutual funds on the market.